Tax Cuts That Make a Difference

It’s time to start talking about a tax cut.

The economy is struggling mightily. Some 15 million people remain unemployed. The Federal Reserve has been slow to act and still is not doing much. The Senate has been unable to find the 60 votes needed to pass anything but minor bills.

The best hope for a short-term economic plan that can win bipartisan support is a tax cut — and not the permanent extension of George W. Bush’s tax cuts, which have been dominating the debate lately. Such an extension is unlikely to win many Democratic votes. Republicans, meanwhile, are unlikely to support more spending, like the national infrastructure project President Obama has been mentioning.

US Capitol Building
US Capitol Building

A well-devised tax cut could be different. Cutting taxes has been the heart of the Republican economic program for 30 years, and last year’s stimulus bill showed that Mr. Obama was open to tax cuts.

The question, then, is what kind of cut can put people back to work quickly.

The last 30 years offer some pretty good answers. For one thing, a permanent reduction in tax rates focused on the affluent — along the lines of those 2001 Bush tax cuts — does little to lift growth in the short term. An across-the-board, one-time cut — like the one that Mr. Bush signed in 2008 or that Mr. Obama signed last year — does more.

But the most effective tax cut for putting people back to work quickly is one that businesses and households get only if they spend money. Last year’s cash-for-clunkers program was an example. So was a recent bipartisan tax credit for businesses that hired workers who had been unemployed for months. Perhaps the broadest example is a temporary cut in the payroll tax for businesses, which reduces the cost of employing people.

Any of these steps would increase the budget deficit, obviously. But relative to the multitrillion-dollar, Medicare-driven, long-term deficit, a temporary tax cut costing a couple of hundred billion dollars isn’t significant. The more pressing problem today, by far, is the weak economy.

The great historical lesson of financial crises is that governments are usually not aggressive enough in responding. That was Japan’s mistake in 1990s, Herbert Hoover’s in the early 1930s and even Franklin Roosevelt’s in the mid-1930s.

In 2008 and 2009, political leaders looked as if they had learned this lesson. In 2010, they seem to have forgotten it.

Sometime in the next four months, Congress will have to decide what to do about Mr. Bush’s original tax cuts, because they are set to expire Dec. 31. Most Democrats favor extending the cuts for households making less than $250,000 a year. Republicans want to make all the cuts permanent, including those for households making more than $250,000.

Republicans argue that a permanent cut in tax rates is the best form of stimulus. Allowing any of the Bush cuts to expire, John Boehner, the top House Republican, said in a speech last week laying out the party’s economic agenda, is “a recipe for disaster.”

As theories go, this isn’t a bad one. You can certainly imagine how a tax increase on the affluent could hurt the economy or how a tax cut for them would lift growth. Theories aside, though, consider what has actually happened in the last three decades.

Mr. Bush signed his original tax cut in June 2001, when the economy had been losing jobs for four months. It then shed jobs for two more years. In the decade that followed the tax cut, economic growth was slower than in any decade since World War II.

If the goal is short-term stimulus, even Ronald Reagan’s much-lauded 1981 tax cut doesn’t appear to have worked. After he signed it, the economy lost jobs for 16 straight months. It didn’t start gaining jobs until after he had raised taxes, to reduce the deficit, in late 1982.

What explains this pattern? Tax rates matter, but people don’t make most decisions based primarily on their marginal tax rates. Mr. Bush’s and Mr. Reagan’s tax cuts were just not powerful enough to overcome the economic headwinds at the time.

Consumers and executives didn’t rush out to spend more money in part because they understood their tax rate would still be lower months or years later. That the Reagan and Bush tax cuts went disproportionately to high-income households, which save more of their income, did not help, either.

In fact, simply sending rebate checks to most households seems to have more punch. If you look at this chart, you can see that consumer spending bounced back in both the second quarter of 2008 (temporarily) and the third quarter of 2009. Those happen to be the quarters when the Treasury Department finished sending the one-time cuts from Bush and Obama.

A simpler approach

Based partly on this history, Moody’s Analytics estimates that a new rebate would have about three times as large an effect on growth next year as would making all the 2001 tax cuts permanent.

Yet a rebate still isn’t the best solution, according to the Moody’s analysis or, for that matter, common sense. Some households will surely put their rebate into a savings account or use it to pay down debt.

That is why the ideal solution tries to leverage government dollars with private dollars. The cash-for-clunkers program did precisely this last year, causing a jump in vehicle sales. So did a 2009 tax break for corporate investment, leading to an end-of-year spike in spending.

The tension with such tax cuts is between targeting and simplicity. Targeted ones can avoid showering too much money on households and businesses that were going to spend anyway.

One possibility is an expanded tax credit for new clean energy projects, which is favored by the White House and by at least two Republican senators, Orrin Hatch and Richard Lugar. Another is an expansion of the tax credit for businesses that increase their work force, like the one sponsored by Mr. Hatch and Charles Schumer, the New York Democrat. This time, though, it would not have to be restricted to companies hiring the long-term unemployed.

The disadvantage of these programs is that people have to figure out if they’re eligible and then fill out forms. A simpler approach — but a less targeted one — would temporarily cut the payroll tax, which finances Social Security and Medicare and is paid by both businesses and workers. By suspending the part that applies to businesses for a few months, Washington could lower the cost of keeping or hiring workers.

Either way, a couple of tax cuts along these lines could make good additions to a bill extending the Bush tax cuts for households making less than $250,000 a year. Economically, the extra cuts would have a bigger impact than an extension of all the Bush cuts. Politically, this kind of bill would force opponents to explain why they instead wanted smaller tax cuts for middle-class families and businesses and a bigger one for the affluent.

Of course, no temporary tax cut will solve the economy’s long-run problems. That’s a harder project, one that involves upgrading the skills of the work force, slowing the growth of health costs, reducing the deficit, lifting exports, restarting healthy wage growth and, yes, simplifying the tax code.

But we won’t make any of those tasks easier by falling into a double-dip recession or enduring months more of halting growth. The aftermath of a financial crisis is usually difficult. It’s not yet time to declare victory.